COVER SHEET

CASE STUDIES
AUDITING
TABLE OF CONTENT

1) Case description
a. Introduction to the case
b. Background about the company 4-Airlines
c. Financial Statement FY 2xx1 & 2xx0
d. Industry Ratios

2) Client Acceptance Decision

a. Learning objectives
b. Client Acceptance Decision task
c. Work tasks

3) Materiality & Risk Assessment

a. Learning objectives
b. Determining Materiality task
c. Work tasks
d. Appendix – Risk assessment form

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 AUDITING
CASE STUDY

CASE DESCRIPTION

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INTRODUCTION TO THE CASE

You have been working as a Certified Public Accountant (CPA) for six years in the audit firm
“Europestars”. Europestars is a medium-sized national CPA firm and member of the
international network “Allstars”. The firm provides auditing, preparation and review of the
clients' financial statements. Furthermore, Europestars provides tax work including the
preparation of income tax returns, tax planning, and consulting and advice involving
information systems, mergers and acquisitions. Most of the clients are in the wholesale and
the automotive supply industry.
Europestars has a Client Acceptance Policy that sets out principles to determine whether to
accept a new client or a new engagement. These principles are fundamental to maintaining
quality, managing risk, protecting the firm and meeting regulatory requirements.
As part of the client acceptance process, Europestars carefully considers the risk
characteristics of a prospective client and conduct several due diligence procedures. Before
Europestars accepts a new engagement or client, Europestars determines if it can commit
sufficient resources to deliver a high quality audit. The approval process is rigorous, and no
new audit engagement may be accepted without the approval of Europestars Managing
Partner. Europestars dedicates significant time and resources to the strict implementation of
their client acceptance policy. All prospective audit engagements are classified as either
“High Risk, “Moderate Risk” or “Low Risk”.
Europestars has set up a team to prepare a recommendation to the Managing Partner for
every client acceptance decision in 2xx1.
Your managing partner at Europestars met the chairman of the audit committee of a
company called “4-Airlines” in the last week of November 2xx1. The chairman indicated that
the company has decided to change its current auditor after some difficult negotiations and
disagreements.
4 Airline’s annual financial statements of the last ten years have been audited by other audit
firms (mandatory audit). The chairman of the audit committee indicates that 4-Airlines has
not signed an audit engagement contract with a new auditor yet, but needs a decision from
Europestars within a short time, as the fiscal year of 4-Airlines ends on December 31.
The managing partner of Europestars, Mrs. Mary Taler, is highly interested having a client in
the air transport service sector, especially one with the favorable market position and
growth potential of 4-Airlines. Most of Europestars’ current audit clients are in the
wholesale and the automotive supply industry. Thus, the managing partner feels that the
engagement presents an excellent opportunity for Europestars to enter a new market.
Knowing the risks involved, the potential responsible partner for the 4-Airlines engagement
for the year 2xx1, Mrs. Sabine Schmid, wants to make sure the client acceptance decision is
carefully considered in accordance with Europestars client acceptance policy.

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BACKGROUND ABOUT THE COMPANY “4-AIRLINES”

4-Airlines is the first audit client of Europestars in the air transport services sector, though
the company has already had a few other clients in the transportation sector. The company
was founded 10 years ago. 4-Airlines issued shares through an initial public offering (IPO)
seven years ago and has been traded on the London Stock Exchange. Until now, it operates
only in the European airspace. The following graph shows the share price development of 4-
Airlines in comparison to the Financial Times Stock Exchange index (FTSE sector Travel &
Leisure) for the last five years.

4-Airlines wants to hire Europestars to issue an audit opinion on their 2xx1 financial
statements. The company has also expressed interest in obtaining help to optimize their
recently installed new information technology (IT) system and the integrated IT-controls.

During a meeting with 4-Airlines' representatives, the following information was obtained
about the company and the air transport industry.

Company overview:
4-Airlines' audited December 31, 2xx0 financial statements report total assets of € 840
million, sales revenues of € 861 million, and net loss of € 53.5 million.
The company operates in two segments: “4-Airlines Passenger”, which comprises the

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company's main scheduled Europe passenger operations and revenue ancillary to the
provision of those services, and “4-Airlines Aviation Services” (4AAS), which focuses on
providing aviation services to customers in Western Europe. The 4AAS supports 4-Airlines’
European activities, as well as serving third-party customers. Its “One Stop to the World”
program provides access to long-haul destinations for its customers, through its
international code-sharing partners at main hubs within the 4-Airlines’ network. The
Company has over 50 new routes focused on connecting its bases to regional centers in
Europe, such as London, Vienna, Rotterdam, Dusseldorf, Amsterdam, Paris and Rome.
As 4-Airlines wants to aggressively expand from a continental to an intercontinental market
4-Airlines plans to use capital from a loan or share capital in the course of a second public
offering.
Since the implementation of a new IT System, there have been ongoing difficulties with the
company's new accounting system.

The representatives of 4-Airlines note that the earnings vary considerably in recent years,
but 4-Airlines enjoys a good reputation and high acceptance among customers.

Last year the company received a qualified audit opinion related to the valuation issues. 4-
Airlines has changed auditors two times within the past 7 years.

Management:

The CEO of 4-Airlines, Mr. Erich Red, is a very experienced manager. He has a hierarchical
leadership style and always strives for market expansion. Mr. Red dominates the
management's operating and financing decision-making process. He is not satisfied with the
share price of 4-Airlines.

In March 2xx1 the Chief Financial Officer (CFO), Mr. Dagobert Free, resigned from 4-Airlines.
The reason for the CFO to leave 4-Airlines was described by the management as being
caused by “personal issues”. A successor CFO, Mr. Donald Haid was appointed in July 2xx1.
He holds a Master degree in Accounting and has 8 years of experience in the airline industry.
In 2xx1, a new reward system for the CEO and a part of the executive team was introduced.
Annual performance based bonuses were set. The current Head of the Controlling and IT
department of 4-Airlines, Mr. Erich Black, doesn’t seem to feel comfortable with the
company’s new IT system.

A client background check reveals that the current CFO three years ago was sentenced to a
fine for theft in a department store. The background check revealed no other legal or ethical
problems with any other of the 4-Airlines’ executives.

Accounting and Information Systems: 4-Airlines has implemented a new, integrated

central accounting system in early 2xx1.
This new complex IT system provides:

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 - An aviation services management, which is a full featured module for processing
service requests with integrated accounting;
- An accounting and finance module that provides necessary tools for managerial and
financial accounting, allowing detailed tracking, reporting and analysis of financial
transactions;
- A human resources module for employees’ documents processing, salary and
bonuses management, and
- A Unit Load Devices’ (ULD) control module that helps to control the entire company
ULD stock, to track their movements’ history and current location.
The former CFO mainly handled last year’s implementation of the new system. Due to
transition problems, the implementation of this new IT system has not yet been completed
and 4-Airlines is still working to modify it to meet the company’s needs. The accounting staff
is dissatisfied with some features of the financial accounting module of the IT system and
has an ongoing training demand. The internal controls associated to the accounting
procedures still don’t seem to work adequately.
There are still some problems regarding the cost calculation, sales invoices overdue and
payables control, e-ticketing and booking over the internet, control for spare parts,
materials, and supplies for aircraft maintenance.
These circumstances have created serious troubles for 4 Airline’s management and
personnel as, among others, reports on receivables and payables outstanding were drafted
inaccurately. As for the online flight ticket booking system, there have been many cases
when the number of tickets booked and purchased for a flight exceeded the total number of
seats in the respective plane. Due to that issue, the company had to pay penalties in 2xx1 of
€ 3 million.
Your office has never audited a company with the specific IT system as the one used at 4-
Airlines. However, your IT team is fairly confident that they will be able to diagnose 4-
Airlines' control weaknesses and help 4-Airlines overcome current difficulties, as they are
experienced in the field of IT-consulting.

Prices, Financing, and Currencies:

4-Airlines reporting and operating results may be significantly affected by price and currency
fluctuations. Credit risks arise from deposits with banks and credit exposure to commercial
customers. However, sales to private customers are mainly settled by using credit card
companies. In order to protect margins against fluctuations of the fuel price, the expected
fuel consumption is hedged to some extent. Following the acquisition of aircrafts with
future deliveries, 4-Airlines will have ongoing financing activities. Financing is diversified
trough sale-and-leaseback transactions and long-term loan financing. A second public
offering is also considered.

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The Industry:

During the last years, the passenger air transport has recorded a constant increase, however
with small decreases in two, due to the global economic crisis. In 2xx1 at the industry level,
airlines generated a return on invested capital exceeding the cost of that capital. Put simply,
for the first time in history airlines made a normal level of profitability. The decrease in the
oil price is a major driver of improved profitability. All indications suggest that in 2xx2 a
continued improvement in financial performance will take place.

Profitable airlines are able to invest in product improvements, fund the growth of stronger
networks, and purchase modern, fuel-efficient airplanes. In addition, it helps passengers to
continue to enjoy great deals on air travel as the costs have fallen by 57% over the last two
decades. The spread of profitability is not yet outstanding. Geographically, about two-thirds
of the industry’s profits worldwide are generated by airlines based in North America, and
while passenger traffic is enjoying robust growth, the cargo business is continuously facing
doldrums.

The expansion of the European Union, the visa requirement elimination for some countries
and the free movement of persons within the Schengen area are positive factors for the
passenger traffic within the European Union, leading to the increase of both the number of
flight routes and the number of passengers.

Another key marker of improved performance is safety. Looking at jet operations, there was
one major accident for every 3.0 million flights in 2xx1. That is a significant improvement on
the five-year average.

A problem in the industry is that security threats continue to loom. The list of security
challenges includes terrorism, cyber-attacks, and the overflight of conflict zones.

Predecessor Auditor:
For new engagements, the ISAs require that the potential new auditor communicates with
the predecessor auditor to determine if there are any reasons for not accepting the
engagement. When you met Donald Haid, 4-Airlines' CFO, to request permission to
communicate with the predecessor auditor, he didn’t seem to like talking about the previous
auditor. He informed you that the predecessor auditor and 4-Airlines' management had
disagreed on some valuation and presentation issues during the prior year's audit. In Mr.
Haid’s opinion, the issues where minor problems and where caused by an insufficient
understanding of 4-Airlines' business, environment and industry. Furthermore, the previous
auditor was not technically skilled enough to support 4-Airlines with its new IT system.
Mr. Haid also indicated that the previous auditor considered - due to the IT-system problems
- to issue a qualified opinion on the financial statements for the year 2xx0. In order to
receive an unqualified opinion, 4-Airlines had to make certain adjustments in the financial
statements. Mr. Haid said that 4-Airlines is convinced that Europestars has competent staff

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to help optimize the IT system. Regarding accounting issues, 4 Airline’s management is
convinced that Europestars has a better knowledge of the airline business and the
environment. Europestars has been highly recommended to the CFO by a friend who is a
member in the same golf club as the managing partner of Europestars. After some
hesitation, permission was granted from 4-Airlines to communicate with the former auditor.
An appointment was scheduled with Mrs. Julia Strong, the managing partner of previous
audit firm. At this meeting, Mrs. Strong did not appear to be surprised that 4-Airlines was
seeking a new audit firm. She said that her firm had assumed when they had considered
qualifying their year 2xx0 opinion that it would be their last year on the job. In general,
working with the management of 4-Airlines was always very comfortable. The CEO and the
other members of the management appear to be people of integrity. However, the CEO was
always unhappy with the audit fees and always saw accounting issues as minor and
unimportant details. He is very interested in stimulating growth and becoming CEO of a large
intercontinental airline company. Moreover Mrs. Strong indicated that the problems her
firm faced with 4-Airlines were primarily related to the complexities and problems with 4-
Airlines' new IT system and management's tendency to aggressive accounting in order to
meet investors’ and creditors' requirements. The CEO and the CFO of 4-Airlines argued
vehemently against adjustments of the financial statements. Mrs. Strong believes that this
was particularly due to the low share price and the capital requirements of Europestars.
Independence Issues:

As part of Europestars’ quality control policies and procedures, every three months the staff
in the assurance service line of Europestars is required to file an updated disclosure of their
personal share investments. The review of the disclosures - as part of the process of
considering 4-Airlines as a potential client - shows that there appears to be no share
ownership issue except that a partner in another firm of the “Allstars” network owns shares
in a venture capital fund. This fund has invested in 4-Airlines’ shares. This investment
represents just over 0.2 percent of the value of the fund's total investments. The partner's
total investment in the fund is currently valued at about € 30,000. No other independence
issues were detected.

Financial Statements:

The client acceptance recommendation team received the past years' financial statements
from 4-Airlines for the years 2xx0 & 2xx1. The balance sheet and the profit and loss account
is attached to this case study. Mrs. Sabine Schmid, the partner who will be in charge of the 4-
Airlines engagement, wants the team to check which information from the financial
statements might be helpful in determining whether or not to accept 4-Airlines as a new
audit client.

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FINANCIAL STATEMENTS 2XX1 AND 2XX0

(preliminary) Balance Sheet

Year ended 31st December 2xx1

2xx1 2xx0
€ thou. € thou.
Non-current assets
Intangible assets 19,950 13,200
Property, plant and equipment 320,550 283,650
Other non-current assets 61,050 57,000
Restricted cash 11,700 10,650
Deferred tax asset 16,950 13,200
Derivative financial instruments 1,200 300
431,400 378,000
Current assets
Inventories 9,600 10,650
Trade receivables 49,800 49,200
Other receivables 102,300 98,250
Cash and cash equivalents 245,400 283,200
Derivative financial instruments 14,550 21,150
421,650 462,450
Total assets 853,050 840,450

Current liabilities
Trade and other payables (156,450) (144,450)
Deferred income (127,050) (115,650)
Borrowings (22,050) (19,500)
Provisions (63,450) (77,850)
Derivative financial instruments (28,200) (28,350)
(397,200) (385,800)
Non-current liabilities
Borrowings (141,750) (159,300)
Deferred tax liabilities (450)
Provisions (46,350) (36,450)
Deferred income (11,100) (12,450)
Employee benefits (22,950) (31,500)
Derivative financial instruments (2,400) (3,900)
Liability for share-based payments (600)
(224,550) (244,650)
Total liabilities (621,750) (630,450)

Net assets (Equity) 231,300 210,000

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(preliminary) Income Statement
Year ended 31st December 2xx1

2xx1 2xx0
€ thou. € thou.
Revenue 935,700 861,150

Consisting of:
Passenger revenue 857,550 792,900
Contract flying revenue 20,850 17,400
Revenue from other activities 57,300 50,850
Revenue 935,700 861,150
Staff costs (149,700) (135,750)
Fuel (152,400) (158,250)
Airport and en route charges (181,050) (163,050)
Ground operations (123,750) (103,650)
Maintenance (31,950) (33,450)
Depreciation and amortisation (48,150) (42,000)
Aircraft rental charges (118,950) (120,900)
Marketing and distribution costs (37,800) (41,100)
Other operating gains/(losses) 6,900 (1,500)
Other operating expenses (85,650) (80,550)
Operating profit/(loss) 13,200 (19,050)
Investment income 1,200 1,200
Finance costs (6,000) (2,250)
Other losses (4,200) (15,300)
Profit/(loss) before tax 4,200 (35,400)
Tax credit/(charge) 6,150 (150)
Profit/(loss) after tax of continuing operations 10,350 (35,550)
Loss on discontinued operations (18,000)
Profit/(loss) 10,350 (53,550)

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INDUSTRY RATIOS

2xx1 2xx0
Return on Equity (RoE) 18.52% 12.10%
Return on Assets (RoA) 3.78% 2.75%
Operating Profit Margin 8.3% 4.7%
Assets to Equity 5.92 5.38
Accounts Receivable Turnover 16.5 22.5
Average Collection Period 22.1 16.6
Debt to Equity 4.9 4.4
Times Interest Earned 5.19 4.37
Current Ratio 0.72 0.75
Share of Fuel Cost in Total Cost 27.30% 31.30%
Share of Aircraft Leases in Total Cost 10.50% 12.50%

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 AUDITING
CASE STUDY

CLIENT ACCEPTANCE DECISION

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LEARNING OBJECTIVES – CLIENT ACCEPTANCE DECISION
1. Explain the objective of the client acceptance process
2. Understand the types of information relevant for evaluating a new audit client
3. List some of the steps an auditor should take in deciding whether to accept a
prospective client
4. Understand the necessary level of knowledge of a client's business to accept the
client
5. Identify and evaluate factors important for the client acceptance decision
6. Describe the procedures for communicating with a prior (predecessor) auditor
7. Understand the auditor's responsibility in using the work of experts
8. Understand the process of making and justifying a recommendation regarding client
acceptance
9. Know the components of the terms of audit engagements
10. Understand the factors that influence the audit fee
11. Understand what an audit engagement letter includes and why these contents are
important.

CLIENT ACCEPTANCE DECISION

As stated within the case description you have to decide about accepting the client 4-
Airlines. To fulfil this task please answer the questions on the next page and prepare a short
memo including some arguments supporting your decision.

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WORK TASK – CLIENT ACCEPTANCE DECISION

Group discussion (up to 5 students) of the following questions and preparation of

presentation slides for each question.
1. An auditor has to collect information for the client acceptance decision. Define at least
five procedures that an auditor should perform to collect relevant information for
his/her decision whether to accept 4-Airlines as client or not.
2. To get a first impression about 4-Airlines’ financial situation and performance use
the financial information integrated in the case to calculate liquidity ratios (i.e.
Accounts Receivable Turnover, Debt to Equity and Current Ratio), profitability
ratios (i.e. ROE, ROA, Profit Margin, Share of Fuel Cost in Total Cost, Share of
Aircraft Leases in Total Cost) and solvency ratios (i.e. Asset to Equity, Times Interest
Earned). Also, compare 4-Airlines’ ratios to the industry ratios provided in the case.
Identify and discuss any major differences. Try to analyze which risks may result
from the alteration of the balance sheet and profit and loss account related key
figures for the auditor.
3. Are there other financial matters that should be considered before accepting 4-
Airlines as a client?
4. Beside financial matters, other aspects should be considered before accepting 4-
Airlines as a client. What nonfinancial matter mentioned in this case study could be
relevant for the client acceptance decision? How important is each of these
nonfinancial matters?
5. 4-Airlines expects that Europestars will help to optimize the new IT system. What are
the pro and cons when an audit firm provides both auditing and IT consulting
services? Discuss whether European regulation and the IFAC code of ethic will allow
Europestars to help 4-Airlines with their IT system and at the same time to carry out a
statutory audit of the financial statement.
6. As indicated in the case, one of the partners in another firm of the “Allstars” network
has invested in a venture capital fund that owns shares of 4-Airlines Equity. Does this
fact violate auditor’s independence? Discuss why or why not, and consider the
consequences.
7. Your team has to make a recommendation to the managing partner as to whether
Europestars should accept the audit engagement of the 4 Airline Company. What
would you recommend? Include consideration of reasons both for and against
acceptance and use both financial and nonfinancial information to justify your
recommendation.

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 AUDITING
CASE STUDY

RISK & MATERIALITY ASSESSMENT

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LEARNING OBJECTIVES – DETERMINING MATERIALITY

1. Identify business risks for the air transport service sector

2. Identify and evaluate the factors important in assessing an audit client’s business risk
and the risk of material misstatement
3. Identify and understand the implications of key inherent and business risks
associated with a new client
4. Determine planning materiality for an audit client
5. Provide support for your materiality decisions

DETERMINING MATERIALITY

After you have accepted 4-Airlines as a new client, you are provided with the preliminary
December 31, 2xx1 financial statement. For the purpose of risk assessment please use the
information given in the description of the case. To fulfil this task please answer the
questions on the next page. For determining materiality please use the Risk Assessment
sheet in the Appendix.

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WORK TASK - DETERMINING MATERIALITY

Group discussion (up to 5 students) of the following questions and preparation of

presentation slides for each question.

1. What risks should be considered when materiality is determined? Identify at least 7

risks applicable to the case study.

2. Briefly list and discuss the five or six most important critical factors or risk areas that
will likely affect how the audit is conducted.

3. Quantify the risks regarding management issues, accounting environment, operating

environment and audit issues and determine a general risk level of the “4 Airlines”
audit, on an evaluation scale from 1 to 5. (please use the risk assessment sheet given
in the appendix)
4. Show the impact of the analysis you have performed within task 3 on the materiality.
5. Determine the materiality, as well as other materiality related aspects according to
ISA 320 (e.g. performance materiality), relying on the information presented within
the case study and the annexes.
6. Describe the relevance of the materiality in planning the audit engagement and
specify if the materiality determined based on the unaudited financial statements can
be changed while the audit is in progress.
7. While performing the audit, the team identifies 5 errors related to the valuation or
the disclosure of the items in the financial statements. What is the impact of the
identified errors on the audit opinion, from the standpoint of the materiality?

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APPENDIX – RISK ASSESSMENT FORM

1 2 3 4 5
Risk factor Very Very
Low Medium High
low high
Management issues (8)
The client’s financial position
The client’s liquidity
The extent to which the financial
statements are used by a third party
The experience and the management
knowledge of those in charge with the
governance
The attitude of the management towards
the financial reporting
The frequent change of the auditors
The previous experience related to the
management control capability
Proper remuneration of the activities, in
accordance with their nature and
associated performance
Accounting environment (9)
Skills of the accounting employees
Attitude of Accounting Department’s
personnel
Risk of inaccurate, inadequate or overdue
financial information
Previous proof on earnings management
Frequency and materiality of transactions
which are difficult to audit
New or complex accounting policies
Complex company and accounting
structure, associated to the size of the
client
Breaks or falls of the accounting system

Evidence suggesting that problems may

arise, associated to the manner in which
operations are accounted for
Operating environment (6)
Nature of the field – growth/fall, new/old

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 1 2 3 4 5
Risk factor Very Very
Low Medium High
low high
Changes in profitability/liquidity ratio
Threats to the return generated by the
activities
Intended material purchases / external
investments
General performance level of the sector
Important client / Renowned client
Audit issues (4)
Records related to previous qualifications
or modifications (regarding opinions
and/or reporting)
Reporting fundamental uncertainties,
including issues related to the going
concern assumption
The probability to encounter difficulties in
collecting audit evidence
Unusual transactions, or industry specific
transactions, as well as practices difficult
to audit
TOTAL
Relevance assigned to each risk
Inherent risk level for each class
Total inherent risk

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